When it comes to funding options for your small business, there are many options. For many entrepreneurs, using existing retirement funds is often the best option.
Using retirement fund assets as your primary financing source has several advantages, as seen in the recent post, Using Retirement Money to Fund a Business: The Pros and Cons. You will not take on additional debt, or be subject to unyielding repayment schedules and daunting interest rates, for example.
Yet those advantages depend on choosing the right approach to financing your new company. If you do an internet search, you will see two prominent options -- using a Rollover as Business Start-Ups (ROBS) strategy or a self-directed IRA.
While both are legitimate and legal options, they are, in many ways, polar opposites. Understanding these differences is important.
Both ROBS and self-directed IRAs allow for funding of a business and provide tax benefits. That is really where the similarities end.
With a ROBS, you establish a new business as a C corporation, create a new retirement fund for the newly created company, and transfer eligible retirement funds from a previous account to the new fund at the new company. The company can issue stock (as a C corporation) that the new retirement fund buys. As the owner, you can use the proceeds of that stock purchase as cash for start-up and expansion costs.
A self-directed IRA lets an owner use retirement assets to invest in stocks, real estate, and other investments. The self-directed IRA is established as either a C corporation or Limited Liability Company.
Self-Directed IRA Limitations
If you want to invest in someone else’s business, then a self-directed IRA might be a good investment choice. However, if you are going to actually work for the business, a self-directed IRA is off the table.
Self-directed IRAs are intended to be passive investment vehicles, with no direct involvement in running the business. The IRA owner cannot have any active involvement in the business and cannot receive any salary from a business in which it invests.
There are other limitations when using a self-directed IRA approach. For example, the IRA owner cannot personally guarantee a business loan.
The IRA, if established as a C corporation, may issue stock ownership shares. However, the owner of the IRA may not receive shares.
Differences with ROBS Funding
Those restrictions with self-directed IRAs are a stark contrast to the way ROBS funding is structured.
With ROBS funding, the owner can be actively involved with the business and can receive compensation from the newly established corporation for services provided. The owner can personally guarantee a business loan.
Another major consideration is if mistakes are made. In both cases, prohibited transactions may subject the owner to various penalties. However, with a ROBS approach, the retirement plan can retain its tax-deferred status.
With a self-directed IRA, if there is a prohibited transaction, the IRA loses its tax-deferred status, retroactive to the year the note was guaranteed.
ROBS 401(k) funding is a smart option for small businesses. Benetrends was the first to introduce this type of funding and for over three decades has helped thousands of business owners use their retirement funds to fuel the launch and expansion of successful companies. To learn more, download The Definitive Guide To 401(k)/ROBS Business Funding.